Finance Exam Topics 11 & 12

New asset costs $12,000. The old asset has a book value of $0 and will be sold for $3,000, increase networking capital by $1,000. Given a 40% tax rate, what is the initial outlay?

$11,200

Book Value

cost - accumulated depreciation

If BV is > sale price....

taxable loss

Company ACE is replacing their ravioli press which is being sold for $250,000 and has a net book value of $50,000. What is the tax implication if the marginal tax rate is 30%?

$60,000 tax liability

Tax Effect

(Market Value - Book Value) * Tax Rate

Drawbacks of Payback period

-ignores the time value of money -does not consider cash flows beyond the payback period -does not consider required rate of return - does not consider risk - does not relate to value

Incremental Cash Flows

Cash flows that are directly related to a specific project and would not occur otherwise.

Payback Period Steps

1. Subtract until you find the 2 years the payback period is between 2. Divide the remaining amount by the next year's cash inflow for your answer

Steps in the Capital Budgeting Process

1. proposal generation - ideas 2. Cash flow estimation - estimate $$$ 3. Evaluation and selection - Payback, NPV, IRR, PI 4. Post audit and review - Provides feedback on how project is doing

Incidental Cash Flows

Cash flows that are not explicit revenues to the project but are indirectly related to a project

Conventional Cash Flows

A series of cash flows with a negative initial outlay followed by a series of positive inflows, constituting only one change in direction.

MACRS

A system used to depreciate an asset by multiplying the total cost of the asset by a percentage determined by the United States Tax Code for each year of the asset's life

If IRR is greater than or equal to required rate of return...

ACCEPT

Good Capital Budgeting techniques should consider: - The required rate of return - the TVM - All project cash flows - All of the above

ALL OF THE ABOVE

The Net Present Value is a measure of: - How much value is added to the firm as a result of undertaking the project - Which projects should be accepted and rejected - The value of a project to the firm - All of the above

ALL OF THE ABOVE

The ideal decision-making criteria for capital budgeting should: -include all cash flows that occur during the life of a project -consider the time value of money -Incorporate the required rate of return on the project -All of the above

ALL OF THE ABOVE

Which of the following is NOT introduced as an evaluation method? - payback period - net present value (NPV) - Internal Rate of Return (IRR) - All of the above

ALL OF THE ABOVE

Suppose a firm introduced a new product. When the sales of this new product reduce the sales of an existing product, the lost cash flow from the existing product line is referred to as:

Cannibalization

The net present value of a project is smaller when:

Cash inflows are pushed farther into the future; this makes the value of the inflows smaller

Which of the following is NOT a part of working capital? - common equity - accounts receivable - inventories - accounts payable

Common Equity Working capital = current assets - current liabilities

To Solve PI

Compute NPV with IO = 0, then divide NPV by the IO

The ideal valuation method should do what?

Consider TVM Consider required rate of return/risk Consider all cash flows

Capital budgeting is defined as:

Determining which projects increase firm value

Capital budgeting is the process of evaluating and planning for purchases of short-term assets. T or F

FALSE

Conventional straight-line depreciation assumes a zero-salvage value for depreciation purposes. T or F

FALSE

IRR is a good decision-making tool when dealing with cash flows that are non-conventional. T or F

FALSE

Increasing working capital results in an inflow to the Initial Outlay and an outflow to the terminal cash flow. T or F

FALSE

The IRR is the rate of return of the capital project where the NPV of the cash flows equals the initial outlay. T or F

FALSE

Using the net present value method, we should reject a capital project with an NPV of less than one. T or F

FALSE

Internal rate of return is calculated by:

Finding the discount rate that forces the NPV of the project to zero.

Which of the following is NOT a potential problem with the IRR approach to capital budgeting? - IRR does not adequately account for risk - The IRR cannot be used to rank mutually exclusive projects - None of the above - There may be multiple IRRs for some projects

IRR does not adequately account for risk Risk is fully removed from the approach

Probability Index

If PI > 1, ACCEPT If PI < 1, REJECT

Get Big Gym is planning to have more accounts receivable next year than this year and it is planning to cover the increase in its accounts receivable by increasing the amount of retained earnings while keeping other current assets and current liabilities accounts constant, net working capital of Get Big in the next year will:

Increase Since account receivable increases, total current assets will increase as well. Current liabilities don't change since the increase in accounts receivable is covered by additions to retained earnings.

Standard Convention

Increases in net working capital represent cash outflows early in the project, and represents cash inflows at the end of the project

Project cash flows should be estimated on what basis?

Incremental

Net Incremental Cash Flow

Incremental cash IN - incremental cash OUT

If a company experiences a taxable loss from the sale of an asset:

It experiences a tax shield that is counted as a cash inflow

Which depreciation method yields the greatest total tax benefits by depreciating the capital asset heavily in the earlier years of the capital project?

Modified accelerated cost recovery system (MACRS)

What are the best methods used in capital budgeting decisions?

NPV and IRR

According to the text, the most preferred evaluation technique we will discuss is:

Net Present Value

The decision rule for using the profitability index states that when the profitability index is greater than __________ then the project should be accepted.

One

The next most valuable alternative that is foregone when a particular project undertaken is a (an):

Opportunity cost

Current expenses

Outlays for goods and services that will be used during the current year (i.e. gas for company car). • Flow directly to the income statement as cost of goods sold, operating expenses, or any other expense category.

Capital expenses

Outlays for items that will provide a benefit to the firm over many years.

taxable gain

Profit that is subject to taxes that results when the market value of an asset is greater than the book value of the asset at the time the asset is sold

If IRR is less than required rate of return...

REJECT

Rule:

Regardless of how net working capital is accumulated, any net working capital associated with a specific capital project is liquidated at the end of the project's life, resulting in a cash inflow. There are no tax effects associated with working capital buildup or liquidation.

Mike's Sports Drinks is considering introducing a new drink to its product line. It is estimated that sales for the new drink will be $20 million; however, 20 percent of those sales will be current customers who have switched to the new drink from an existing drink on their product line. It is anticipated that these customers would not have switched if the new product had not been introduced. What is the relevant sales level to consider when deciding whether or not to introduce this new sports drink?

Relevant Sales = 20,000,000 - (20,000,000 x .20) $16,000,000

Exxon is used as an example of what financial concept?

Risk Characteristics

Terminal cash flow is calculated by...

Salvage Value +/- tax effects of capital gain/loss + net working capital

All of the following are weaknesses of payback period as an evaluation tool except: - Some projects have multiple paybacks - All cash flows are not considered - Cutoffs are subjective - Timing of cash flows is not considered

Some projects have multiple paybacks The payback approach does not suffer from multiple solutions (IRR does)

Cash flow estimates should not reflect:

Sunk costs

Annual cash flow = incremental earnings after tax + depreciation reversal. T or F

TRUE

Capital budgeting is the process of evaluating and planning for purchases of long-term assets. T or F

TRUE

The NPV of a project is set to zero when solving for the internal rate of return. T or F

TRUE

The NPV of a project is set to zero when solving for the internal rate of return. T or F?

TRUE

Using the internal rate of return method, we should accept a project in which the IRR is greater than the cost of capital. T or F

TRUE

If BV is < Sale Price...

Taxable gain

What should not be included in capital budgeting analysis?

The consulting fee associated with a previously completed market analysis

Which of the following is not an ideal criterion for the methods used to evaluate a capital investment project? - The method must include all relevant cash flows - The method must consider sales of previous products as a benchmark - The method must account for the time value of money - The method should account for the varying levels of risk - None of the above

The method must consider sales of previous products as a benchmark

Which of the following is an ideal criterion for the methods used to evaluate a capital investment project? - All cash flows should be included, which might consist of opportunity costs, sunk costs - The method must account for the success of previous projects - The method should set the required risk to be constant for all projects that will be considered - The method should consider the timing of the projects cash flows - none of the above

The method should consider the timing of the project's cash flows

terminal cash flow

The net cash flow that occurs at the end of the life of a project, including the cash flows associated with (1) the final disposal of the project and (2) returning the firm's operations to where they were before the project was accepted.

Payback period

The number of years required to recover the initial cash outlay of a project; the simplest of the three methods discussed

Net Present Value (NPV)

The present value of an investment's expected cash inflows minus the costs of acquiring the investment; the preferred capital project evaluation method

Capital Budgeting

The process of evaluating and planning for purchases of long-term assets.

Internal Rate of Return (IRR)

The rate of return that a firm earns on a capital project

Profitability Index (PI)

The ratio of payoff to investment for a proposed project

Cannibalization

The reduction in sales of a company's own products due to introduction of another similar product.

Tax Shield

The tax savings that result from offsetting positive earnings with negative income.

Hurdle Rate

The term for the required rate of return when considering the IRR of a project.

When in doubt....

Use NPV!

The decision rule for using the NPV states that when the NPV is greater than _________ the project should be accpeted.

Zero

Sunk Costs

a cost that has already been incurred and cannot be recovered Ex: Research and development cost

straight-line depreciation

a method used to depreciate an asset by taking the cost of the asset minus its salvage value, all divided by the asset's life.

differential cash flow

cash flows that result from the operations of a project each year

Net Working Capital

current assets - current liabilities

Simplified Straight-line Depreciation

makes the additional assumption of a zero salvage value

If the firm's working capital investment increases as a result of accepting a new project, the amount of the increase should be:

subtracted from project cash flows when the increase occurs.

Positive NPV means

we expect to earn more than we invest